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The newest source of capital available to most private entities is a tax-exempt bond that Congress included in this year’s American Recovery and Reinvestment Act.

The notion of for-profit firms using tax-free financing isn’t totally new. But for the past few decades, only manufacturing companies could obtain that type of debt, and they’ve used it for expansion projects and equipment purchases.

Now, though, almost every company and developer can apply for the tax-exempt Recovery Zone Facility bonds to finance new construction, renovations and property purchases. The bonds are offered through the city of Grand Rapids and Kent County. The act allocated $79.9 million in RFZ bonds locally, with $54.8 million assigned to the county and $25.1 million to the city.

City and county commissioners will decide who will get the financing, after reviewing staff recommendations. Once applicants are approved, they have to go to the designated issuers of the bonds: the Economic Development Corp. of Grand Rapids or the Michigan Strategic Fund. The EDC will issue bonds for projects approved by the city, while the MSF will do the same for those ratified by the county.

“They are the ones that I call the conduits. They actually issue the bonds for the benefit of the developer or the company. By going through that conduit, that is what gives those bonds a tax-exempt status, because federal law says the issuer has to be a governmental entity or an entity created by a governmental entity,” said Dick Wendt, a partner at local law firm Dickinson Wright and a counsel to the city on municipal bonds.

“But then somebody has to buy that debt,” he added. “The responsibility of the company or developer is to find somebody to buy that debt once those bonds have been issued.”

The first step in applying for a bond is to have a creditworthy project, and that means having a bond buyer or a bond underwriter in place. Wendt said there are two ways to do that. One is to find a direct buyer such as a bank that would buy the bond and hold it in its investment portfolio rather than sell it or parcel it off.

Another way is to have an underwriter agree to sell the bonds, usually investment firms like Robert W. Baird or JPMorgan Chase & Co., which normally sell bonds in denominations of $5,000.

“But in order for an underwriter to make those bonds saleable, the bonds have to be secured by something, and what these are commonly secured by is a letter-of-credit issued by a bank. So in case there is a default, the investor — the public that buys those bonds — can look to the bank that has issued the letter-of-credit for security on that debt,” said Wendt.

“Then the bank that issues the letter-of-credit, or if a bank makes a direct purchase, they take the collateral from the developer. So they’ll get a mortgage on the property. They may get personal guarantees or a security interest in machinery or equipment, furniture, fixtures — that sort of thing,” he explained.

Of course, the main issue is a bank has to be willing to participate, whether the method is a direct purchase by a lender or a sale through an underwriter backed by a letter-of-credit. The city and county require a bank commitment with an application because both need to know that a project can be financed. The potential fly in the ointment, though, is that banks are being very cautious about lending money these days.

City Economic Development Director Kara Wood recently told the Business Journal that her office hadn’t received a bond application, and that didn’t seem to surprise her.

“I think it’s going to be a while yet. Developers need to find financing first, and I’m sure you know the difficulty there,” she said.

Although the city and county are approving applications, neither is committing their full faith and credit to any bonds that get issued — nor is Washington, D.C.

So what is the federal government’s role in the RFZ bonds? Congress altered Internal Revenue Service rules to allow private firms other than manufacturers to obtain tax-exempt financing, meaning the buyers don’t pay taxes on the interest from bonds they purchase. The advantage for sellers is that their cost to finance is lower, which can add up to some real money.

“Usually they say the difference between taxable and tax-exempt debt is about 2 to 3 percent. If you do the calculation on $10 million on what the interest is at 5 percent a year and what the interest is at 7.5 percent, it’s a pretty significant benefit. In some cases, it makes deals work,” said Wendt.

“Why is the federal government doing that? For economic development purposes.”

The allocations Congress made to the city and county are really IRS limits on how much tax revenue the government is willing to lose to ignite economic activity here. And that offer is only good until Dec. 31, 2010. In total, the act has allocated $15 billion nationwide; Michigan was awarded the nation’s second largest allocation at $1.159 billion.

Wendt said the IRS has generally held a negative attitude to these types of bonds because the agency views the securities as little more than a loss of tax revenue to the government, and that’s why the RZF bonds carry a limit on allocation and a deadline for issuing bonds.

Wendt also explained that tax-exempt bonds first became available to private companies back in the mid-1950s, but later was restricted to manufacturers. The RFZ bonds can be used to finance projects such as office buildings and hotels, which normally don’t qualify for tax-free financing.

“In the beginning, way back in the 1950s, into the 1960s and into the early- and mid-1970s, you could also do bonds for other things like you can with (RZF) bonds. But the IRS felt there were abuses of that so they cut back and limited it in 1986 to just manufacturing — core manufacturing operations,” said Wendt.

“When McDonald’s went around the country and built many of their restaurants with tax-exempt bonds, the IRS felt that was an abuse. Back then, the bonds were commonly referred to as ‘burger bonds.’”

Perhaps the last big project locally to be financed with tax-free bonds happened close to 30 years ago, when Amway Corp. converted the former Pantlind Hotel into the Amway Grand Plaza Hotel a few years before the IRS restricted the use of those securities.

“After they changed the law, you couldn’t do hotels. Now, for this very limited period, someone could come in — assuming they were creditworthy — and they could finance a hotel again with tax-exempt bonds,” said Wendt.

But the RZF bonds aren’t completely free of restrictions. Residential rental properties, golf courses, country clubs, massage parlors, hot tub and suntan facilities, racetracks, casinos and any store whose principal business is the sale of alcohol aren’t eligible for the bonds.

Wood said applicants who are approved can also apply for the standard incentives such as brownfield and state business tax credits. Owners of properties in the city’s nearly tax-free Renaissance Zone can also apply.

Wendt suggested an applicant should have a project worth at least $2 million in order to make the expense that comes with issuing bonds worthwhile.

“There are costs involved, obviously, in getting these bonds issued, and that can vary. It’s more costly to underwrite, as one might expect, than to direct purchase,” he said.

“If you’re going to have all these additional soft costs, the interest-rate savings at some point diminishes to nothing, and you certainly don’t want to do these just to do these. You want to be able to recognize the savings.”

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